Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries

US$ @ 6-mth Japanese LIBOR + margin"* US$ @ 6-mth LIBORSince all the payments would now be made in US dollars, company Awould not be exposed to foreign exchange risk anymore, and the productfully captures its view. In a sense, the Japanese LIBOR only acts as a kindof reference rate. Again, the difficulty for this kind of swap is to calculatethe fair value of the fixed margin at the inception of the swap. Fat marginswere charged by investment banks initially, with the margins coming downgradually in recent years.TAILOR-HADE STRUCTURESSo far we have only introduced swaps where coupons are exchanged basedon some reference rates. Features of the other big family of derivatives,options, could be added to plain swaps to create some new type of products.The simplest one is the option on a swap, or swaption. A typical deal is:in one year's time, the buyer has the right to enter into a plain vanilla 3-yearswap, where he pays fixed at 6% and receives floating LIBOR every sixmonths. There is a very active over-the-counter (OTC) market in tradingthese instruments, with different maturities of the option (one year in theabove example) and different maturities of the underlying swaps (3-year above).As with other types of options, a premium has to be paid upfront to purchasethe right. This is different from typical swap structures for which nocounterparty has to pay any upfront fees because the deal should be fair toboth parties at inception.Another common type of OTC swaps with option features is the extendibleand puttable swaps. These instruments allow one counterparty the rightto extend or cancel the swap at the end of a specified period. For example,an extendible swap can be:fixed @ 5.5%* 6-mth LIBORin the first 2 years. After 2 years, company A has the right to extend theswap for a further year. If it does not exercise the right, the swap terminatesat year 2.Different Types of Swaps B0|